Bettina Edmondston: Making the case for value investing

Bettina Edmondston: Making the case for value investing

TURNING points in the stock market are usually only visible in hindsight. In the face of the storm, the exact point where market leadership changes is not always clear. This is why attempting to time the market is a fruitless exercise. The value end of the market, however, allows investors to buy into attractive businesses where revenues, profits and dividends are likely to grow for many years ahead.

Value means many things to many people. A key concern is to avoid the so-called value traps: businesses that look cheap but are actually in long-term decline. Focusing on high-quality, global leading businesses with the ability to grow their revenue over the economic cycle, have strong balance sheets and are able to finance their business in tough times is key.

As American investor James O’Shaughnessy wrote in his book What Works on Wall Street: “Buying high PE [price-earning multiple] stocks regardless of their market capitalisation is a dangerous endeavour.” We believe now is the time for investors to have a look at under-appreciated value businesses and that the tide may be turning for growth stocks.

Looking at data going back to 1926, value has outperformed growth in roughly three out of five years, with an excess average annual return of 3.3 per cent. Periods of economic expansion tend to favour value stocks while growth stocks have outperformed only during periods of depression, recession and below-trend growth.

In this context, the outperformance of growth against value since 2009 is similar to the situation in 1930s after the great depression, and we believe it is similarly incongruous. These trends can persist for some time. Nevertheless, the current significant divergence in valuations of both value and growth stocks is causing investors to review their portfolios and start to seriously consider some of the opportunities presented by recent market price declines.

Until recently, investors continued to favour shares in companies with high PEs, so long as the share prices kept on rising. The problem comes when investors realise that they are holding expensive shares and their growth is less than expected. Investors have a history of overpaying for growth that may not materialise.

The continued rerating of growth stocks and the derating of shares in many other sectors this year has been staggering. Examples of growth stocks include Amadeus and Microsoft, which have rerated to levels that are pricing in growth rates that are unlikely to be sustained over the long term. It seems that the technology and e-commerce sectors are reaching similar levels as tech did in the late 1990s and the US housing companies did in the early 2000s. This feels dangerously close to bubble territory.

In the case of Microsoft, for example, the year one PE has expanded from 13 times to 27 times over the last five years. At the same time the dividend yield fell from 3.2% to 1.7%. So, although investors might like Microsoft as a business, it may no longer be considered an attractive investment.

The derating of many shares has provided new investment opportunities. Companies such as Michelin have derated over the last five years to a PE of less than 9 times our forecast 2018 earnings and yield more that 4%. This compares respectively to a PE ratio of 14 times and 2.7% yield at the start of the year. This is incredible value given that tyres are rarely a purchase that can be deferred, and replacement tyres represent 75% of the market.

One thing we all know is that many uncertainties persist and it is always difficult to correctly time when to invest. Only hindsight will verify if we are correct. No one can predict how factors such as Brexit and US-China trade wars will evolve but a lot of potential bad news is now encapsulated in share prices. Undoubtedly patience will be required, but when valuations are attractive, investors should consider their options, rather than more comfortable purchase when share prices are much higher.

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